978-0134200057 Chapter 4 Lecture Notes

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Chapter 4

THE ECONOMIC ENVIRONMENTS FACING BUSINESSES

OBJECTIVES

4-1 Explain the value of economic analysis

4-2 Differentiate the types of economic environments

4-3 Explain the idea of economic freedom

4-4 Differentiate the types of economic systems

4-5 Interpret indicators of economic development, performance, and potential

4-6 Profile elements of economic analysis

CHAPTER OVERVIEW

When companies source, manufacture, and/or market products in foreign countries, they

encounter fascinating and often challenging economic environments. Chapter Four first explores

the economic environments of countries in which an MNE might want to operate by discussing

the importance of economic analysis and identifying the major dimensions of that process. It

then compares and contrasts key macroeconomic indicators, such as economic growth, inflation,

and the surpluses and deficits reflected in the balance of payments. Finally, it reviews the

characteristics of the major types of economic systems, explores the principles of economic

freedom, and concludes by highlighting the connection of the conceptual anchor of this chapter,

economic freedom, to meta-measures of the vitality of developed, developing, and emerging

economies.

CHAPTER OUTLINE

OPENING CASE: EMERGING ECONOMIES: COMEBACK OR COLLAPSE [see

Figure 4.1]

Despite far-ranging opinions, most agree that the ongoing integration of national economies into

the global market has changed economic aspects of the business environment. Some

commentators see trends that indicate a flattening of the world, where others emphasize the entry

of billions of people into the global marketplace from China, India, and the former Soviet

countries. These developments and trends will powerfully impact one’s job, company, future, and

even one’s country. The global economic meltdown impacts the business environment in many

ways, including an increase in trade barriers and risk aversion. As the global economy improves,

many see this as an inflection point and realize that the need to understand the economic impacts

on the global business environment is more important than ever. Studies predict a shift from the

rich and powerful countries of the twentieth century to many emerging economies in greater

Asia. This shift can be seen as we track the global economic output. [see Fig 4.1] All of these

changes represent opportunities and threats for global players in the new economy.

I. INTERNATIONAL ECONOMIC ANALYSIS

In the IB realm, cultural, political, and legal systems influence a company’s decision on

where, when, and how to do business. This chapter completes our profile of the

environmental domains of IB, evaluating how economic systems shape a market. Studying

an economic environment helps managers make better investment choices and operating

decisions. Resource constraints require managers to identify which countries in the world

warrant investment as well as those they must avoid.

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Various principles help managers better assess economic environments, including:

1. System Complexity. Economic environments are dynamic systems. The intricacy of the

simplest economic system defies straightforward specification. Stipulating models that

definitively represent a country’s economic performance and potential as well as work

reliably in all types of economic environments is difficult.

2. Market Dynamism. Market changes can make today’s valid measures dubious

tomorrow. Evolving circumstances, compounded by disruptive situations and puzzling

trends, generate anomalies and exceptions that convert comebacks into collapses.

3. Market Interdependence. Just as no one is an island, no country is isolated. The

consequence of cross-national connections means actions here influence outcomes there.

A. Navigating Challenges

Figure 4.2 shows how managers navigate these challenges.

II. WHO’S WHO IN THE GLOBAL BUSINESS ENVIRONMENT

In IB, the development level of a country is the single most important indicator of who’s

who. It influences nearly every aspect of business, including the nature of consumer

demand, organization of productive activity, attitudes toward foreign investors, regulatory

transparency, sophistication of market systems, and the freedom one has to make effective

and efficient business decisions. Hence, estimating the attractiveness of a country as a place

to do business and, once there, making smart investment and operational decisions depends

on how well managers understand its economic environment.

A. Developed Economies. Developed economies generally have high-income levels,

extensive industrialization, advanced technological infrastructure, and high standard of

living. Developed economies steadily shift to diversified, service-oriented activities that

rely on information and technology to support product and process innovation.

Manufacturers in developed economies have outsourced many activities to low-cost

factories in the emerging economies.

B. Developing Economies. Developing economies generally have low-income levels, slight

industrialization, incomplete infrastructure, and lower standards of living. Significant gaps

exist in economic and social characteristics between developed and developing

economies. Some argue that developing countries have strong communities and social

ties, extraordinary self-sufficiency, and admirable work ethics. Alternatively, one regularly

finds higher infant mortality, shorter life expectancy, lower literacy levels, poorer public

hygiene, insufficient health care, and inadequate nutrition in developing countries relative

to their developed counterparts.

C. Economies in Transition/Emerging Economies. At the high end of developing

economies, we find faster growing, quickly industrializing countries such as China,

Mexico, Indonesia, and the Philippines. Increasingly, these countries are referred to as

economies in transition, emerging markets, frontier markets, or newly industrializing

countries; generally, description defaults to emerging economies. Emerging economies are

experiencing accelerating growth in productivity, manufacturing, exporting, and per capita

income, resulting in material improvements achieved in years, rather than decades. Their

financial systems, political institutions, and market infrastructure steadily modernize.

Market liberalization promotes foreign investments and growing exports, deregulation and

privatization improve business efficiency, and expanding economic freedoms encourage

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entrepreneurialism. Prosperity and progress support a growing middle class, whose

economic aspirations fuel a revolution of rising expectations, thereby spurring society and

the state to improve living standards. When one speaks of the emerging economies, many

point to Brazil, Russia, India, and China (referred to as the BRICs) [see Map 4.1.]

D. The Issue of Different Degrees of Development.

Different reasons explain different levels of economic development in different countries.

Analysis directs attention to the economic, political/legal, and cultural moderators of

development. [see Table 4.2.].

III. ECONOMIC FREEDOM [see Map 4.2.].

Economic freedom holds that one has the right to work, produce, consume, save, and

invest in the way that one prefers. It measures the absence of government coercion or

constraint on the production, distribution, or consumption of goods and services beyond the

extent necessary for citizens to protect and maintain liberty. The Economic Freedom Index

estimates economic freedom in a particular nation. In principle, this index measures the

degree that a nation accepts Adam Smith’s thesis that “basic institutions that protect the

liberty of individuals to pursue their own economic interests result in greater prosperity for

the larger society.” The ultimate score ranges from zero (no freedom) to 100 (full freedom);

hence, the higher the index for a particular nation, the higher its degree of economic

freedom. Determining factors include: property rights, freedom from corruption, fiscal

freedom, government spending, labor freedom, business freedom, monetary freedom, trade

freedom, investment freedom, and financial freedom. Countries ranking highest on this

index tend to enjoy both the highest standards of living as well as the greatest degree of

political freedom. Paradoxically, despite the documented benefits of economic freedom, just

5 countries, out of 178, have policies that maximize it. The surge in state capitalism helps

explain why many emerging and developing economies deemphasize economic freedom.

LOOKING TO THE FUTURE__State Capitalism: Detour or Destination?

The impressive performance in many countries with emerging and developing economies

suggests that free market economics is no longer the only viable route to modernization. Many

see China as the bellwether; it has used state capitalism to develop and direct the world’s

fastest-growing economy that, in turn, has powered the swiftest, most extensive rise out of

poverty any nation has ever seen. Throughout Asia, the Middle East, Africa, and Latin America,

authoritarian governments emulate China’s model. Some dismiss state capitalism as inevitably

unacceptable.

IV. TYPES OF ECONOMIC SYSTEMS

An economic system is the set of structures and processes that guide the allocation of scarce

resources and shapes the conduct of business activities in a nation. The spectrum of systems

is anchored on one end by capitalism and on the other by communism. Free-market

(capitalistic) economies are built upon the private ownership and control of the factors of

production, while communism is based on state ownership of economic activity.

A. The Market Economy. A market economy describes the system where individuals,

rather than government, make the majority of economic decisions. Key factors include

consumer sovereignty, the freedom of market entry and exit, and the determination of

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prices according to the laws of supply and demand. Credited to Adam Smith, the

laissez-faire principle, i.e., nonintervention by government in a country’s economic

activity, states that producers are driven by the profit motive, while consumers determine

the relationship between price and quantity demanded. Thus, scarce resources are

allocated efficiently and effectively. The high standards imposed by a market economy

are based on some preconditions. Four of these preconditions indicate a basis for

consistent growth: sound macroeconomic policies and solid macroeconomic background,

fair and transparent political institutions, open trade, and high levels of education.

B. The Command Economy. Also known as centrally planned economies, command

economies are built upon the government ownership and control of the factors of

production. Central planning authorities determine what products will be produced in

what quantities and the prices at which they will be sold. Most often, the totalitarian aims

of communism gave the highest priority to industrial investments and military spending at

enormous expense to the consumer sector.

C. Mixed Economy. Mixed economies fall between the extremes of market and command

economies. While economic decisions are largely market driven and ownership is largely

private, government nonetheless intervenes in many economic decisions. The extent and

nature of such intervention may take the form of government ownership of certain factors

of production, the granting of subsidies, the taxation of certain economic activities, and/or

the redistribution of income and wealth.

V. ASSESSING ECONOMIC DEVELOPMENT, PERFORMANCE, AND POTENTIAL

Managers use different economic measures to assess a country’s level of performance and

potential. In practice, generally, managers begin an analysis by looking at the monetary

value of the total flow of goods and services in the economy of a nation.

A. Monetary Measures

1. Gross National Income (GNI) measures the value of all production in the

domestic economy together with the income that the country receives from other

countries (in the forms of profits, interest, and dividends), less the same sorts of

payments that it has made to other countries. Among monetary aggregates, GNI

provides the broadest measure of economic performance.

2. Gross Domestic Product (GDP) is the total market value of goods and services

produced by workers and capital within a nation’s borders; it provides the truest

measure of national economic activity. Technically, GDP plus the income generated

from exports, imports, and the international activities of a nation’s companies equal

its GNI.

3. Gross National Product (GNP) is the total value of all final goods and services

produced within a nation in a particular year.

B. Improving Economic Analytics

GNI, GDP, and GNP estimate an economy’s absolute performance. Despite strengths, they

can distort country comparisons. Managers improve the economic indicators by adjusting

for the (1) growth rate of the economy, (2) number of people in a country, and (3) local cost

of living.

a. Rate of Economic Growth. Monetary aggregates take a static snapshot of an

economy at a point in time. Hence, they do not capture its rate of change.

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Interpreting present and forecasting future performance prompts considering an

economy’s growth rate.

c. Population Size. Managers routinely adjust indicators by the number of people

who live in a country. Adjusting GNI by population, therefore, lets managers

qualify a country’s performance for its demographics. A larger population base

provides the opportunity for greater productivity, but can also create additional

challenges for an economy. An analyst must review the population size and

determine GNI per capita to establish a true picture of a nation’s standard of living.

d. Purchasing Power Parity. While exchange rates define the number of units of one

currency that are required to purchase one unit of another currency, they do not

determine what a unit of currency can buy in its home country, i.e., exchange rates

do not incorporate differences in the cost of living. Purchasing power parity

(PPP) represents the number of units of a country’s currency required to buy the

same amount of goods and services in the domestic market that one unit of income

would buy in another country. PPP is estimated by calculating the value of a

universal “basket” of goods that can be purchased with one unit of a country’s

currency. [see Map 4.3.].

C. The Wildcard: The Shadow Economy

Sometimes called the black, gray, or parallel market, or the informal economy, the shadow

economy includes the extra-legal activities (e.g., driving an unlicensed taxi, street trading, or

unregistered day care center) as well as well as illegal doings (e.g., prostitution,

drug-slinging, illicit gambling, cigarette and alcohol smuggling, product piracy) that fall

beyond official statistics. All countries experience the effects of the shadow economy; they

are particularly influential in developing economies. Some countries are moving to include

shadow activities when measuring production in their economy.

D. Sustainability and Stability

Sustainability and stability perspectives hold that the objective of economic activity is to

create an environment for people to enjoy long, healthy, and happy lives.

1. Sustainability. Green economics holds that an economy is a component of, and

dependent on, the natural world. Green measures gauge economic performance in

terms of the effect of current choices on long-term sustainability. Estimators of

economic progress toward improving happiness includes:

a. Net National Product (NNP) measures the depletion of natural resources

and degradation of the environment that result from making and consuming

products

b. Genuine Progress Indicators (GPI) begin by applying the same accounting

framework used to calculate GDP. It then adjusts for the corresponding costs

of reduced environmental quality, health and hygiene, livelihood security,

equity, free time, and educational attainment.

c. Human Development Index (HDI). Estimating a country’s degree of

human development, in terms of the physical, intellectual, and social

standards that shape its overall quality of life, helps managers measure

market potential. The UN translates this view into the HDI and its

components: Longevity, measured by life expectancy at birth; Knowledge,

measured by the adult literacy rate and the combined primary, secondary,

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and tertiary gross enrollment ratio; and Standard of Living, measured by

GNI per capita (PPP).

2. Stability. Universal affluence, despite its appeal, is presently impossible. Rather

than assessing an economy’s potential for increasing affluence, perspectives like

happynomics or welfare economics encourage incorporating elements of

psychology, health, security, and sociology. More fundamentally, they advocate

redefining the traditional performance standards of wealth, income, or profit to

reflect principles of well-being, quality of life, and life satisfaction. Estimators of

economic progress toward improving happiness include:

a. Your Better Life Index (YBLI): Developed by the Organization for

Economic Cooperation and Development (OECD), the YBLI advocates

evaluating economic performance in terms of matters that people worldwide

believe are important (e.g., housing, jobs, social relationships, health,

security, work–family balance, education) but that fall beyond the narrow

scope of monetary measures.

b. Gross National Wellness Index (GNWI): GNWI measures a country’s

capacity to promote individual well-being in terms of mental, health, work,

income, social relations, economic, retirement, political, and environmental

standards.

c. Happy Planet Index (HPI): The HPI holds that the fundamental logic of

monetary metrics are misaligned, overly emphasizing growth at all costs

while downplaying its costly, destabilizing, and often destructive

externalities. In the realm of the HPI, progress is defined not in terms of

economic development, but through success in achieving a sustainable

well-being for all.

POINT—COUNTERPOINT: Growth: Positive and Productive

POINT: Many people believe growth is not only good but it is necessary for our continued

existence as an individual, a company, and even as a society. They argue that the benefits of

growth include moral stability, reduction in poverty, business and government prosperity,

improved potential for a peaceful and environmentally friendly world, and a very human benefit

of a better and longer life.

COUNTERPOINT: Others believe that although growth has its benefits, you cannot discount the

costs. These costs are short and long term and include inevitable economic inequalities,

misleading benefits of growth, and the impact on sustainability and individuality. Finally, they

posit that the current rate of growth is not possibly sustainable.

VI. ELEMENTS OF ECONOMIC ANALYSIS

A. Integrating Economic Analysis

Managers often consider meta-models to improve their understanding of the absolute and

relative potential of an economic environment. Popular indices include

1. The Global Competitiveness Index (GCI). The GCI summarizes the performance

and relationship among 110 variables that compose 12 so-called “pillars of

competitiveness” within a nation. These pillars tap dimensions like financial market

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development, macroeconomic environment, technological readiness, market

efficiency, and innovation.

2. The Global Innovation Index (GII). Rather than focus on the scale of research

and development, the GII estimates a nation’s capacity to imagine ideas, leverage

them into pioneering products, and, in the process, generate knowledge,

competitiveness, and wealth.

3. The World Competitiveness Index (WCI). The World Competitiveness Project

assesses a nation’s ability to set and sustain a business environment that enables

enterprises to compete, prosper, and create wealth. Four factors determine a nation’s

competitiveness: economic performance, government efficiency, business

efficiency, and infrastructure.

4. The Where-To-Be-Born Index (WTBBI). The WTBBI holds that how well a

country provides opportunities for a healthy, safe, and prosperous life helps explain

both its current and future economic environment. The WTBBI evaluates 11

indicators, such as geography, demography, quality of life, per capita income, and

life expectancy.

B. Economic Freedom, Innovation, and Competitiveness

Economic freedom has a strong relationship with a country’s relative competitiveness and

innovation performance. Table 4.9 indicates that countries with higher degrees of economic

freedom consistently show higher degrees of competitiveness and innovation. [see Table

4.9.]

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